By Matt Richey (TMF Verve), Tom Gardner, and Zeke Ashton (TMF Centaur)
April 27, 2000

This is a continuation of last week's article on analyzing stocks using Rule Maker metrics such as the Foolish Flow Ratio and the Cash King Margin.

Measuring Cash Generation With the Cash King Margin
The Cash King Margin follows in the footsteps of the Flowie by revealing important truths about the cash dynamics of a business without any unnecessary complexity. The Cash King Margin is the equivalent of the standard net margin, except that it measures profits by using the cash flow statement instead of the income statement. What's the difference, you say? Almost nothing at all, but in fact everything in the world.

The income statement measures earnings, whereas the cash flow statement measures cash. We prefer the latter. Here's why: Accountants have been known to massage the income statement in order to produce "earnings." The income statement includes a lot of stuff that can get between sales and net income, and a lot of those items don't have much to do with a company's cash profitability. In contrast, the cash flow statement reveals the unmanipulated truth of what's going on inside the business. While standard net margins are important, what hits the bank account at the end of the day -- CASH, as measured by the cash flow statement -- is a lot more real from an economic standpoint. The Cash King Margin lets us shove all that income statement stuff aside and see what really happens to the money that the company is bringing in via sales.

Here's how the Cash King Margin is calculated:
 

(Operating Cash Flow - Capital Expenditures)

Sales

To calculate the Cash King Margin, we only need two line items from the cash flow statement: operating cash flow and capital expenditures. With only a little practice, your eyes will soon clue in directly on these two important numbers, and all the other numbers will fade to the background. Let's run an example using Intel (Nasdaq: INTC) as we did last week. Below, we've extracted just the essential data from Intel's 1997-1999 cash flow statement:
 

Year ended December 31   1996 1997 1998 Cash flows from operating activities (in millions)   Net Income $7,314 $6,068 $6,945 Net cash provided by operating activities $11,335 $9,191 $10,008 Cash flows from investing activities   Additions to property & equipment ($3,403) ($3,557) ($4,501)

The first number on the cash flow statement that we zoom in on is the bottom line of operating cash flow, entitled "Net cash provided by operating activities." We usually just refer to this number as "operating cash flow." We prefer this number to be significantly larger than the corresponding net income figure.

Because most companies, including Intel, require regular capital expenditures to build and maintain plants and purchase new equipment to keep the business growing, we want to go one step further and see how profitable our companies are on a cash basis after the deduction of these capital expenses. We refer to the resulting figure as a company's Free Cash Flow, or FCF.

To this end, we have to delve down into the section of cash flows from investing activities. The number we look at here is "Additions to property, plant, and equipment (PP&E)," or some similar variation. Some companies will call this "capital expenditures." Subtract this number from our operating cash flow. For Intel, we can see that the company spent $3.4 billion in the PP&E category. Subtract that from the operating cash of $11.335 billion, and we get free cash flow of $7.9 billion, which happens to be ahead of net income for the year. This won't always be the case, and we like to see our companies post free cash flow equal to or greater than net income. Dividing our FCF of $7.9 billion into annual sales of $29.4 billion (from the income statement) yields us 26.9%. This is the Cash King Margin for Intel.

That 26.9% represents the real economic profitability on every dollar of sales. As for guidelines, we're looking for companies with a Cash King Margin that's higher than the corresponding standard net margin. If a company passes that litmus test, then we know its income statement is an accurate depiction of economic reality, and may in fact be understating the company's true profitability.

With the Flow Ratio and Cash King Margin in your analytical tool box, you'll be prepared to dig down and really determine whether a company is conserving and generating cash for long-term value creation.

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